I initially wrote the following as an internal memo to our team this morning, but thought it might be interesting to the broader crypto world.

We’re seeing something play out in real time (but slow motion) that we’ve long expected. The crazy valuations of early stage projects are falling to earth.

6 months ago, a decent team with an idea on a napkin were raising at $100m+ valuations, sometimes $250m+. This happened because investors mistakenly extrapolated the amazing returns of 2017 ICO investing forward.

The average return on a pre-ICO or even ICO investment prior to around April 2017 was outrageously high. The projects from before this period were generally valued at <$10m pre-ICO and <$40m at ICO time. They were generally high quality projects, since it wasn’t easy to raise $20m in an ICO prior to 2017. The ‘get rich quick’ entrepreneurs mostly weren’t on the scene yet, so the ratio of good projects to bad was relatively high, and the valuation entry points were relatively low. It’s far easier to earn a 5x on a $10m valuation than on a $100m valuation.

Combined with the general market run-up in the second half of 2017, every one at every stage had a chance to profit. The earliest pre-ICO investor got a mark up to the later stage pre-ICO investor, who got a mark up to the ICO investor, and all were able to exit on exchange listing to an exchange buyer, who often also profited. In the last 6 months, the exchange buyer has consistently been losing badly, so they’ve mostly stopped buying. This means that the late stage pre-ICO investor also started often losing. Until now, the early stage pre-ICO investor was still winning, but it’s like dominos, and we’re nearing that last domino falling as well.

As a result, many investors have been more public about their aversion to investing at ‘crazy’ valuations, even when offered deep discounts to those crazy valuations, since those deep discounts still look overpriced and there’s likely to be no one to sell to in the near future. For example, a 75% discount to a $200m valuation is still $50m, which is still aggressive for an early stage project with limited usage, network effects, and switching costs. Sometimes I find myself looking at a project thinking, “I’d never invest at in this at $50m, but maybe it’s interesting at $50m if that’s a 75% discount to the $200m valuation others are or will pay? That line of thinking isn’t inherently irrational, but it is dangerous. It’s a trader’s mentality, not an investor’s mentality, and it relies on market timing, not investment underwriting.

These things play out in slow motion, because both investors and projects are reluctant to realize mark-downs, and the lack of a liquid exchange price means they can fool themselves. One way this plays out is what we’re seeing – much smaller raises at the high valuations. For example, consider a project that had an initial angel round raising $2m at $10m, and now raising $10m at $200m. If they find the $10m of investment at the higher, those early investors think they have $40m worth of tokens. But while the $200m valuation is ‘fair’ from an accounting perspective, it’s not real from an economic perspective – there’s only $10m worth of liquidity at that price, so holders of the $40m worth of tokens can’t exit at that level. If even half of them tried, it would likely crash the valuation 50%+, maybe much more.

As a result, there’s been a long lag in pre-ICO valuations coming down to earth to match the public markets and changing investor sentiment.

This may produce some attractive investments in the near future if investors ‘panic’ and look for OTC liquidity to exit their pre-ICO investments, but since many of these valuations have so far to fall, and investors are very reluctant to realize 80%+ losses, this will likely both take some time to play out, and willing sellers at attractive levels may be scarce.

This market dynamic is not a surprise to most of the investors in the space – many understood that they were playing musical chairs, and just hoping to be able to find a chair before the music stopped. Timing the music is far harder than identifying the game.

The very best projects will survive their valuation write-downs and ultimately thrive. And hopefully we’ll see new projects come to market at reasonable levels, 1/5 the valuations of the recent batch soon that will provide attractive investment opportunities.

Timing these cycles is challenging, and the illiquid nature of the assets means that to successfully time them, you have to anticipate the cycle by 3+ months (maybe 6+ months now given longer lock-ups.) Doing this at the margin makes sense (e.g. deploy more capital in bear markets, less in bull markets), but I think it’s generally best to do so as shifts to an underlying consistent investment strategy. In other words, rather than deploying nothing for 9 months, and then racing to deploy, I think it makes sense to have an underlying “slow and steady” approach to allocating capital to top decile projects each quarter, and to maybe cut that pace in half when valuations seem high, and to double it when valuations seem cheap. To the extent an investor wants to further time the general market, this can be done by increasing or decreasing liquid cryptocurrency exposure.

That’s the end of the internal memo. I’m getting asked by a lot of projects what this market dynamic means for them. There’s no “one size fits all” advice I can give – it depends on your project, the current size of your treasury relative to your roadmap, and your ambitions. But there are a few specific suggestions I can give.

First – be realistic. A down round (aka raising at a lower valuation than your last raise) is optically bad and you may reasonably choose to avoid it by simply not raising at all if your treasury is sufficient. But…if your project needs that influx of capital to thrive, swallow your pride. Whether you exchange $5m for 10% or 30% of your project’s tokens is trivial relative to maximizing the odds of your project surviving and succeeding. 30% of 0 is still 0. And 10% of $1 billion is still $100m. Momentum and optics matter, but they ultimately matter far less than actually building a product/service/network that offers value to users.

Second – think about what you really need. Sure, it might’ve been nice to build a $50m warchest, but what do you really need to execute on your vision? Think critically about your roadmap and what you need financially to execute on it.

Third – love your investors. A great many investment agreements in our industry are on questionable legal and regulatory footing. Some are explicitly ‘donations’, others are utility token agreements with lengthy contracts that exist in a regulatory gray area. Many ‘good actor’ projects likely violated legal and regulatory fine print. JP Morgan and Credit Suisse routinely violate contracts with one another over delivery of treasury bonds for example. This *could* result in a lawsuit, but almost never does – rather they resolve things amicably instead of racking up huge legal bills, incurring negative publicity, and damaging relationships. When the market is up – no one looks too closely at contracts or thinks about lawsuits. When markets are down, this becomes an issue. Recognizing that early stage investing is largely based on trust and that this industry is largely one based on relationships, projects should be careful to treat investors as valued partners in all regards. One example – many projects are currently re-writing their investment agreements to better comply with current SEC guidance. Such re-writes can be viewed as exploitative by investors or as necessary for the project’s success. Pivots, contract re-writes, and corporate restructurings may be important for a project’s success which every investor desires for their portfolio holdings. Project leaders must communicate both the substance and intent of such changes. This is important to ensure that investors view such changes as for their own benefit as well as the welfare of the project.

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About Ari Paul

Ari Paul is co-founder and CIO of BlockTower Capital.
He was previously a portfolio manager for the University of Chicago's $8 billion endowment, and a derivatives market maker and proprietary trader for Susquehanna International Group (SIG).
Ari earned a BA in political science from the University of Pennsylvania, and an MBA from the University of Chicago with concentrations in economics, entrepreneurship, strategic management, and econometrics & statistics. Ari is a CFA charterholder.

What do you think about the method of deriving crypto valuations as a whole? Do you try to model it using something like the equation of exchange, the use case of the token (as described here: https://multicoin.capital/2018/02/13/new-models-utility-tokens/) or purely speculation (based on the price investors are ready to pay)?

Totally depends on the project and token economic model. Some tokens (like Binance’s BNB) can be modeled today. Others (like ETH) are almost entirely hypothetical. For very early stage investments with uncertain monetization models, VC investors typically look at the addressable market, a reasonable % of that the project may capture, and then a % chance of success.

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